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LULU – Can’t Celebrate This Victory, Laurent

Takeaway: ‘Better than the whisper’ but still bad qtr. The growth plan/strategy here is so weak, and must change. Risk is that this qtr bought time.

Conclusion: We’ll take the stock upside, but there was so much about this quarter that we didn’t like. The biggest of which is this quarter being treated as a victory by a management team that has little vision as to what this company could become, and even less of a plan to get there. The risk here is that this event takes pressure off the Board to make a major change, like swapping out the new CEO for another new CEO. With the stock in the mid-$40s, the discussions around LBO valuation support (that made sense at $37 3-months ago) are probably off the table. At some point sooner or later (probably sooner), we’re going to have to make the call as to whether the current team can steer this ship. That’s an easy call based on the team in place. They can’t. For now, however, the market is paying us to wait.

 

FULL DETAILS

We’ll take this LULU print, as it validates much of the rationale as to why we added it to our Best Ideas list on June 15. We think all the reasons behind our bullishness still hold true. But truth be told, for everything we liked about this print, there were three things that we didn’t.  We still think that this company needs structural changes, including swapping out top management. Our biggest concern is that this print buys the current team some time. When it comes to LULU, we don’t like time.

 

 

Things That Concerned Us

  1. The internal perception of this earnings report is flat-out dangerous. Keep in mind that Laurent Potdevin (CEO) never experienced a turnaround for a public company. He’s been at the helm of LULU for eight months, and the stock has done nothing but go down. This will feel like a long-awaited win for him, which we think could take away a sense of urgency to make badly needed organizational and operational changes. When a CEO feels upbeat in the face of de-leveraging +13% top line growth into a (-13%) EPS decline, it worries us.
  2. We didn’t need to hear Laurent allocate real estate in the first 90 seconds of the conference call talking about ‘Prints, Mesh, and newness.’ Seriously, there are bigger issues to address here. Constant currency comps were flat, and the women’s business was off 2-3%. The company may have beat the beared-up whisper number, but this was not a victory.
  3. His four key priorities are a) product, b) brand, c) guest experience, and d) international expansion. We actually think this is the most troubling thing of all. Show those priorities to a real company like Nike, Under Armour, or Restoration Hardware. They’d laugh at this. Lululemon might argue with us on this, but based on everything we have ever seen, the company does not have a strategic plan. Unlike quality management teams, LULU can’t tell you how big its different target markets are, where the areas of opportunity are for winning share of wallet, which competitors are going after those dollars, what physical and intangible assets are required to achieve its goals, and how much capital it will cost.
  4. We remain concerned about Gross Margins. Merchandising Margins clearly remain under pressure. But that’s not what bugs us. We can live with another 300bp slide in merch margins. The problem is that the company still thinks that it can return to a gross margin rate in the ‘mid 50s’. We’d be hard pressed to build a quorum of investors that would pay up for LULU as a margin expansion story. Most people (including us) will pay for one thing – sheer unadulterated growth. If that top line growth carries a few hundred basis points of margin along with it, then that’s a huge bonus. But if this company has to sacrifice some margin points as it builds up its infrastructure to facilitate the next leg of growth, then we’ll take that all day. Management simply does not get this.

 

LULU – Can’t Celebrate This Victory, Laurent - LULU GM waterfall

 

What We Liked

  1. Revenue came in ahead of our model. That hasn’t happened with LULU in a while.  
  2. New store productivity remains steady at $1,100-$1,200. Good sign.
  3. Online sales were +30%, improving 630bp sequentially, and also improving 270bp on a 2-year run rate. That’s probably the best number of the quarter. And was in line with what we were expecting
  4. The new transitional set to bridge Summer and Fall was definitely a winner. That’s what drove the business in July, and buoyed the top line for the quarter.

 

Clearly, we’re uncomfortable with the company as it exists today, but we think that the opportunity to fix LULU is huge. We’re pleased with the stock reaction, but fully acknowledge that it takes pressure off the Board to make a major change. With the stock in the mid-$40s, the discussions around LBO valuation support are probably off the table. At some point sooner or later, we’re going to have to make the call as to whether the current team can steer this ship. That’s an easy call. They can’t. For now, however, the market is paying us to wait.

 

LULU – Can’t Celebrate This Victory, Laurent - lulu financials

 

09/09/14 09:12 PM EDT

LULU – More Ways To Win Than Lose

 


Takeaway: Great category, solid brand, weak company, and a horrendous mgmt team. But in the $30s, we think there are more ways to win than lose.

 

DETAILS

We like LULU, but it is not for the typical reasons we traditionally look for in a long. We added the name to our best ideas list on June 15 because of our view that things were so pathetically bad at LULU, that it would lead to positive change. Add on what we thought was capitulation by the sell-side (LULU currently has its lowest Buy ratio in history), and very defendable downside in the low-mid $30s due to attractive LBO/acquisition math, we think that this is ripe for a restructuring.  Even most LULU bears would probably admit that this is a very strong brand in a superior category with global appeal – they’ll probably just argue that the competition is too fierce and LULU is ill equipped to face it head-on. We actually agree with that logic. That’s why it needs to be changed radically from what we see today.  Yeah, John Currie is on his way out as CFO – that’s a plus. Also, Chip Wilson sold half his stake to Advent, and we think that the rest of his stake is on the way out.  But, we think the change we’ll see will be a lot bigger than that. The problem is that this is a global mid-cycle growth company approaching $2bn in sales, but it has a management team that is appropriate for a sub-$500mm localized brand.

 

As for what’s next on the ‘change agenda’, we think that the speed of change depends on the company’s own financial results. If the next couple of quarters pan out as we think – which is not very good – then we think the most probable outcome is that the Board fires Laurent Potdevin – the CEO it hired just 8 months ago. He’s simply not the right guy for the job. Never was, and never will be. He’s only led small brands like Toms and Burton, but he simply does not have the skill set to make LULU a great global brand with efficient operations across multiple distribution channels. Our view is that the only reason the Board approved Laurent is because Chip simultaneously agreed to give up his Chairman title if Potdevin was named CEO. That move left Wilson powerless (no Chair, no CEO, no majority, NO power), which led to him unwinding his stock. It also suggests that the Board is not married to Potdevin, and we think it will make the right call in replacing him if need be. We think that there’s an 80% chance that Potdevin is gone in a year’s time. 

 

There are a lot of other changes as well beyond human resource management. Other changes should be made regardless of who is at the helm – like developing a competitive pricing process. LULU is the worst company that we’ve seen in many years when it comes to appropriately changing the prices on its product as the selling season progresses. It needs the information systems, potentially physical outlets, and definitely a more sophisticated system to sell aged inventory online and ship directly from stores. And yes, it might even need a wholesale model. These are all decisions that should be vetted by the management team LULU deserves – but does not have.

 

So basically, if trends weaken further and it is clear that this management team cannot create value and grow this business profitably, then we think we’ll see a completely new executive team put in place to make it happen. Advent did not buy back 14.8% of LULU for $845mm after all these years to passively watch it die on the vine. So in this case, we think Bad News = Good News. If by chance (and we think it would be sheer luck) that this management team gets this engine running, then that’s probably good for the stock as well.  Good News = Good News.

 

We’re very careful about these ‘things are so bad that it’s good’ calls, because they usually have a way of missing even lowered expectations and destroying value.  But that mattered to us when the stock was near $70, and even earlier this year when it was in the $50s. But with the stock in the high $30s, sentiment worse than it has ever been (EVER is a long time), and value investors increasingly coming out of the woodwork exploring with us what the trough earnings number is for LULU (it’s $1.50, by the way), we’re simply not as concerned at current levels.  Could it trade down on horrible print? Yes, but we think things are bad, not horrible.  In a perverse way, we’d like to see LULU faceplant this quarter. Because we don’t think the equity market would punish it commensurately to the economic impact of the miss itself, but it would be an event that would likely cause the Board to shake things up.  Ultimately, there is $4bn in revenue to be realized here – likely at a high-teens margin. That’s $3-$3.50 in EPS power. At $38, that’s 11.6x earnings, and 7.5x EBITDA. Sounds pretty defendable to us. We just need a team in place that can deliver.

 

LULU – Can’t Celebrate This Victory, Laurent - LULU sentiment

 

THINGS TO CONSIDER FOR THE QUARTER

  • In LULU’s 28 quarters as a public company it has beat estimates 27 times by an average of 16.5%. Over the past 8 quarters the average beat was 7%. There have been pre-announcements and guide downs along the way, especially over the past 12 months, but in general LULU doesn’t miss.
  • Luon Recall was 3/18/13 and Luon was back on shelves 6/4/13 about a month into the 2nd quarter last year
  • Chip comments on Bloomberg fell at the start of the 4th quarter (11/5/13)

 

Revenue

  • Internet traffic rank which takes into account organic visits and page views per visit was up 25% relative to all other sites on the internet.
  • Monthly traffic improved sequentially in June and July from trough levels in May and was up 68% in the quarter. A 2000bps improvement sequentially from 1Q14. The improvement could be driven by LULU jamming more inventory through the e-pipe. That could have negative margin implications, or if it does not result in better e-comm sales it could simply mean that the company did a lousy job converting. But the trends initially look decent.

 

LULU – Can’t Celebrate This Victory, Laurent - LULU traffic rank rank

LULU – Can’t Celebrate This Victory, Laurent - LULU visits qvisits

 

Gross margin – key negative driver here are product margins

  • Over the past 5 quarters (1Q13 -1Q14) product margins have been down by 90bps, 220bps, 220bps, 270bps, and 310 bps respectively. Two year comp in 1Q, -200bps. Management guided margins down another 300bps for the upcoming quarter that would assume product margins down 200bps, 50bps from fx, 30 – 40bps hit from new Ohio DC. Much of deleverage comes from mix away from core to seasonal which has lower IMU due in part to inefficient supply chain and inventory chase.

SG&A

  • Investments listed below and 14 pop-up shops adding an incremental $10mm in SG&A

Revenue Drivers

Near term stop gap measures intended to drive ‘traffic and sales’. These all seem weak at best. But it’s what LULU has called out.

1) Allocating additional floor space to men’s at store locations in Santa Monica, Vancouver, and Miami

2) London – on track to do in excess of $2,200 per square foot in year one

3) A social media platform focused on Brand Ambassadors

4) In-store tablets allowing guests to shop online inventory

5) Paid search advertisement

6) 14 pop up shops across the US and Canada open from April through September

 

Long term (these make more sense to us, but only partially address LULU’s problems)

1) Additional 120 stores to be added across North America

2) 40 international stores (20 Europe, 20 Asia) by the end of 2017 in addition to anything added on top of 30 store base in Australia and NZ

3) Go to market calendar – Spring/Fall 2015

4) Rebalance of core and seasonal product – Starts in 2H14 but won’t be fully implemented until 2Q15

5) Revamped product engine – 1Q16

 

Guidance Considerations

Getting within spitting distance of management guidance for the quarter is not terribly heroic. To get to the mid-point of guidance and in line with consensus for the quarter calling for revenue of $375mm - $380mm and EPS of $0.28-$0.30 we need to assume the following…

1) Revenue growth of 9.6%. Square footage growth of 20% YY, -4.3% consolidated comp (-9% store and +22% DTC).

2) Gross margins down 300bps and flat sequentially from the first quarter on the 2yr trend line

3) SG&A up 25%, implying 440bps of deleverage

4) EBIT margins down 738bps YY.

5) EPS growth of -26%

 

A little tougher to get to annual guidance. To get to the mid-point of guidance and in line with consensus for the full year calling for revenue of $1.77bil - $1.80bil and EPS in the range of $1.71-$1.76 we need to assume the following…

1) Revenue growth of 12%. Square footage growth of 18%. Flat consolidated comps (-5% store and +24% DTC).

2) Gross margins down 170bps to 51%.

3) SG&A up 24%, implying 300bps of deleverage

4) EBIT margins down 465bps

5) EPS growth = -10%



McCullough on Fox Business: The Biggest Risks to the Markets and Economy Right Now

Hedgeye CEO Keith McCullough sits down with "Opening Bell" host Maria Bartiromo on Fox Business to discuss the biggest risks to investors right now.


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.65%
  • SHORT SIGNALS 78.63%

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water

Takeaway: The second worst outflow all year in U.S. equity funds increase our caution on T Rowe Price and Janus Capital closing out the year

Investment Company Institute Mutual Fund Data and ETF Money Flow:

 

In the most recent 5 day period ending September 3rd, equity fund flow trends worsened substantially with domestic stock funds putting up the second worst weekly outflow all year with $5.3 billion being redeemed from the category (only surpassed by the $8.8 billion withdrawn by investors in the first week of July). Intermediate term trends in domestic funds are now drastically negative with outflow in 18 of the past 19 weeks with over $47 billion withdrawn by investors. While mean reversion would argue for now being a good time to look at the leading equity fund managers, we point to fund flow entering the seasonally weakest part of the year in 3Q and 4Q and that the average draw down since 2007 has averaged 40 weeks with over $113 billion lost (and thus this redemption sequence in domestic funds could be on going). We continue to recommend investors avoid shares of T Rowe Price (TROW) and Janus Capital (JNS) - see our recent TROW research here.

 

 

Total equity mutual funds had outflow in the most recent 5 day period ending September 3rd with $4.0 billion being redeemed in all stock funds as reported by the Investment Company Institute. The composition of flow trends continued to be weighted towards International stock funds with a $1.2 billion inflow buffering a substantial $5.3 billion redemption in U.S. stock funds. The inflow in International funds makes it a perfect 35 for 35, i.e. inflows in all 35 weeks of 2014. Conversely however, domestic trends are very dour with now 18 of 19 weeks of outflow now totaling over $47 billion lost. The running year-to-date weekly average for all equity fund flow continues to decline and now settles at a $1.3 billion inflow, now well below the $3.0 billion weekly average inflow from 2013. 

 

Fixed income mutual fund flow continues to be solid with $2.4 billion coming into the asset class. The inflow into taxable products of $1.7 billion made it 28 of 30 weeks with positive flow. Municipal or tax-free bond funds put up a $661 million inflow, making it 33 of 34 weeks with positive subscriptions. The 2014 weekly average for fixed income mutual funds now stands at a $1.9 billion weekly inflow, an improvement from 2013's weekly average outflow of $1.5 billion, but still a far cry from the $5.8 billion weekly average inflow from 2012 (our view of the blow off top in bond fund inflow). 

 

ETF results were mixed during the week with inflows into equity funds but redemptions in passive fixed income products. Equity ETFs put up a $5.6 billion subscription while fixed income ETFs put up a $1.5 billion outflow. The 2014 weekly averages are now a $1.7 billion weekly inflow for equity ETFs and a $895 million weekly inflow for fixed income ETFs. 

 

The net of total equity mutual fund and ETF trends against total bond mutual fund and ETF flows totaled a positive $738 million spread for the week ($1.6 billion of total equity inflow versus the $869 million inflow within fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52 week moving average has been $3.9 billion (more positive money flow to equities), with a 52 week high of $31.0 billion (more positive money flow to equities) and a 52 week low of -$37.5 billion (negative numbers imply more positive money flow to bonds for the week). The 52 week moving average chart displays the declining demand for all equity products (funds and ETFs) for the safety and security of fixed income. 

 

Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.   

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 1

 

 

 

Most Recent 12 Week Flow in Millions by Mutual Fund Product:

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 2

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 3

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 4

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 5

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 6

 

 

Most Recent 12 Week Flow Within Equity and Fixed Income Exchange Traded Funds:

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 7

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 8

 

 

Net Results:

 

The net of total equity mutual fund and ETF trends against total bond mutual fund and ETF flows totaled a positive $738 million spread for the week ($1.6 billion of total equity inflow versus the $869 million inflow within fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52 week moving average has been $3.9 billion (more positive money flow to equities), with a 52 week high of $31.0 billion (more positive money flow to equities) and a 52 week low of -$37.5 billion (negative numbers imply more positive money flow to bonds for the week). The 52 week moving average chart displays the declining demand for all equity products (funds and ETFs) for the safety and security of fixed income. 

 

ICI Fund Flow Survey - Punching a Hole in the Hull...Equity Fund Trends Taking on Water - ICI chart 9 

 

 

 

Jonathan Casteleyn, CFA, CMT 

 

 

 

Joshua Steiner, CFA



INITIAL CLAIMS - A SOFT START FOR SEPTEMBER

Takeaway: Another week of decelerating improvement in the labor market appears to be rolling August's softness into September.

Less Good, Again

Last week, we profiled the labor market data as "still good, but less good". The same could be said about this week's numbers. We're cautious to make too much out of a holiday week, but the numbers suggest a real step backward. The y/y change in NSA initial claims, our preferred measure, actually rose +2.1% this week. Only the third time that's happened YTD. That took the rolling 4-wk average to -7.2% y/y vs -8.5% in the prior week. The data is still reasonably good, but it's not as strong as what we saw in the June/July time frame. 

 

Taken in conjunction with the weak August payroll report last week, this morning's data suggests that softness is continuing into September.

 

The Data

Prior to revision, initial jobless claims rose 13k to 315k from 302k WoW, as the prior week's number was revised up by 2k to 304k.

 

The headline (unrevised) number shows claims were higher by 11k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims rose 0.75k WoW to 304k.

 

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -7.2% lower YoY, which is a sequential deterioration versus the previous week's YoY change of -8.5%

 

INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 2

 

INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 3

 

INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 4

 

INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 5

 

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INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 10

 

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INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 19

 

 

Yield Spreads

The 2-10 spread rose 9 basis points WoW to 197 bps. 3Q14TD, the 2-10 spread is averaging 199 bps, which is lower by -22 bps relative to 2Q14.

 

INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 15

 

INITIAL CLAIMS - A SOFT START FOR SEPTEMBER - 16

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT

 


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